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The Facebook IPO: A finance lesson

by Jay Prag

Social networking company Facebook sold stock to the public for the first time May 17 in what financial professionals call an initial public offering - an event that had been heralded for months and touted as a "sure thing" by pundits.

The Facebook IPO was a flop.

An IPO is usually cause for great excitement for a company and its investors. Historically, IPO stock increases in price by about 10 percent on its first day of trading, and that price increase translates into a nice return for the investors who are able to buy an IPO stock.

But most investors don't get to buy IPO stock; the majority of IPO stock is sold to large institutions such as mutual funds and pensions. The stock that is sold to individuals is almost always sold to wealthy, longtime clients of the brokers who are responsible for selling the new stock.

This traditional allocation of IPO stock has been called unfair by some observers, but the financial professionals in charge of initial public offerings, known as investment bankers, say that IPOs are risky and that only large investors are able to tolerate the risk.

The Facebook IPO has been the cause of some controversy and finger pointing, but it has confirmed one thing: Stocks are risky, and new stocks are very risky.

Facebook's initial offering price, the price paid by those who bought the stock from Facebook, was $38 per share. The stock ended its first day of trading on the stock exchange slightly above $38 but in the subsequent weeks, the stock has fallen as low as $25 per share.

The Facebook IPO is telling. This is not some obscure Internet company that no one has ever heard of. Facebook had a movie made about it before its stock was sold to the public. Millions of people use Facebook every day.

And yet, its stock was overpriced when it was sold to the public and in the weeks since its IPO, billions of dollars were lost - not made - by its investors.

Imagine the outcry if thousands of middle-income investors had each been able to buy a few hundred shares of Facebook at $38 only to see the price fall by more than $10 per share in less than a month.

The lesson that we learned - and I can only hope all of the young people who use Facebook did learn it - is that there are no sure things, especially in the stock market.